From the Dow to the S&P - What's in an Average?

When we ask “how did the market do today?” we usually answer with averages like the Dow and the Standard & Poor’s 500. Yet we tend to be a little unclear about the way these averages are computed, how they came about, and what they really reflect. A better understanding of market indices and benchmarks can make you a better informed and more confident investor. 

The Dow Jones

The three best known Dow Jones averages are the Industrials, including 30 stocks, the Transportations, including 20 stocks, and the Utilities, with 15 stocks. The originator, Charles H. Dow, began working on the concept of a benchmark, or market barometer in 1884, to make some sense out of past and present market movements, and to develop a system for successful investing. The results of his research, an 11 stock average, (mostly railroads,) were first published in The Wall Street Journal on May 26, 1896. By 1929, the original average had split into Industrials and Railroads, (later renamed Transports), and a third average, comprised of major utilities, was added. Over the years, Dow Jones has expanded its indices into many other areas including specific industries, economic sectors, individual countries and global markets.

Today, the Industrials remain the most closely watched Dow average.  It is still made up of 30 stocks, with a mean market capitalization of $119 billion. The top five Dow component companies include IBM, Caterpillar, Chevron, 3M, and United Technologies. Criteria for a company to be included in the Dow include reputation, long term economic relevancy, broad sector representation, market capitalization and substantial investor interest. Changes in the Dow occur infrequently, usually the result of mergers, acquisitions or reorganizations.

The Dow averages are price-weighted (as opposed to cap-weighted averages like the S&P 500.)  Since the information in the Dow numbers is primarily price related, it will reflect the most recent transactions in the market in an immediate way that cap-weighted indices do not.

The S&P 500

The Standard and Poor’s corporation provides information on dozens of averages and benchmarks for various industries, sectors and geographical areas throughout the world. Its best known U.S. benchmark, the S&P 500, is a five-hundred stock index of the largest publicly traded firms in the U.S, which represent more than 75% of the total market value of all US stocks. The S&P 500 is actually a component of a core 1,500 stock average which includes the MidCap 400, and the SmallCap 600. Taken together, these three represent the 1,500 largest publicly traded companies in the U.S.

In a cap weighted index like the S&P, the representation of each company is based on its market capitalization, or the share price times the number of shares outstanding. As of July 2011, the average market capitalization of the companies in the S&P 500 is $24 billion. Changes in both a company’s market weighting, as well as its price, can have an impact on the change in value of the average. The largest component companies of the S&P 500 include Exxon, Apple, Chevron, IBM and General Electric. Criteria for inclusion include liquidity, financial stability and reporting transparency, as well as size and share float. In contrast to the Dow, which can go many years without changes, the list of companies comprising the S&P is intentionally dynamic, in order to reflect the gain and loss in market capitalization of its components.

No one average or benchmark is better in and of itself; keep in mind that reality is only approximated by the numbers and metrics we rely upon. The contrasting methodologies and databases of these indices allows for different perspectives in the way each average tries to describe in numbers the complexities and uncertainties of the financial world. And the numbers are only at best, a brief illumination of this complex and many dimensioned reality.

Steven Weber

TAGGED: Investments
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